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Chapter 5

Chapter 5- Markets in Action.docx

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Kalina Staub

Chapter 5- Markets in Action Welfare economics  Welfare Economics- How allocation of resources affect the wellbeing of consumers and producers ; how well off people are  Demand = willingness to pay (WTP) = value  Supply = sellers willingness to sell = cost of production  Consumer surplus = willingness to pay – price set by market  Area under the demand curve and above P* (dotted line)  Formula for triangle [(base x height) divided by 2]  Consumer surplus = ½ (Pmax-P*)(Q*)  Producer surplus  Producer surplus = area above the supply surve and below P* from 0 to Q*  Producer surplus = ½(P*-Pmin)(Q*)  Total Surplus (Economic surplus)  TS= CS +PS (+ government tax revenue – government expenditures)  Efficiency = Rx maximized  Example: Qd=10-2p and Qs= 3p with P=2 and Q= 6 (6,2)  Consumer surplus = ½(5-2)(6) = 9  Producer surplus = ½(2-0)(6) = 6  To find Pmax and Pmin, find y-intercepts (set equations to 0) of demand and supply equations 4.3 Where Elasticity Matters Continued - Taxes and Subsidies  Purpose of taxes is to raise government revenues  When analyzing taxes, we want to calculate:  Pbuyer = Pseller + tax  Pseller = Pbuyer – tax  Quantity bought and sold with tax (Qtax)  Tax revenue = (Tax) x (Qtax)  New Producer surplus and consumer surplus  Deadweight loss- loss in total surplus due to the implementation of a tax (when talking about taxes) and from market inefficiencies  Tax Incidence- division of the tax burden  Taxes can be imposed on either buyers or sellers  Implementing a tax on buyers is equivalent to implementing a tax on sellers  Sellers- supply shift to left by amount of tax  Buyers- Have to pay more so demand curve shifts to left by the amount of the tax 1. Graph curves and solve for P* and Q* 2. Find new supply or demand equation and solve for Qtax 3. Plug Qtax into original supply and demand equations to get Pb and Ps 4. Calculate CS and Ps using Pb and Ps 5. Calculate tax revenue and total surplus 6. Find deadweight loss by taking original total surplus – total surplus with tax 7. Calculate tax incidence = Pb – P* (buyer) and P* – Ps (seller) Qs=Ps -> Qs = Pb – t 5.1 The Interaction Among Markets  No market/industry exists in isolation from the economy’s many other markets;  Feedback- A change in one market will lead to changes in many other markets which will in turn lead to changes in the first market  Size of feedback effect affects the analysis  Partial- Equilibrium Analysis: The analysis of a single market in isolation, ignoring any feedbacks that may come from induced changes in other markets and is a legitimate method of analysis: o If specific market is quite small relative to the entire economy, changes in the market will have relatively small effects on other markets; feedback effects on the original market will, in turn, be even smaller  General-Equilibrium Analysis: The analysis of all the economy’s markets simultaneously, recognizing the interactions among the various markets o Takes into account the various relationships and feedback effects among individual markets 5.2 Government- Controlled Prices  Government Price Controls- Policies that attempt to hold the price at some disequilibrium value Disequilibrium Prices  At any disequilibrium price, quantity exchanged is determined by the lesser of quantity demanded or quantity supplied  Price below equilibrium price = quantity exchanged will be determined by supply curve  Price above equilibrium price = quantity exchanged will be determined by demand curve  Solid portions of S and D curves show actual quantities exchanged at different disequilibrium prices (Page 106, Figure 5-1) Price Floors  Price Floor- Minimum permissible price that can be charged for particular good/service  Price floor set at or below equilibrium has no effect because free market equilibrium remains attainable; non binding  Price floor set above equilibrium will raise price = binding o Binding price floors lead to excess supply; either unsold surplus will exist, or someone (usually government) must enter market and buy the excess supply  Reasons for price floors:  Workers and farmers who would have earned less at lower equilibrium price are now better off; elastic demand (agricultural products) = producers earn more even though they sell fewer units of the product  Organized groups persuaded government to sell their own g/s above free market levels  Consumer surplus = Area 1; CSfloor= ½ (Pmax-Pfloor)(Qd) where Qd is the quantity echanged  Producer surplus= Areas B and D; PSfloor= ½ [(Pfloor-Pmin) + (Pfloor –PQd)](Qd) -> trapezoid  Deadweight loss= TSo – Tsfloor; (A +B + C +D +E) – (A + B + D) = C +E  Under price floor, consumers are worse off because consumer surplus deceases; CSo > CSfloor  Under price floor, producers are better off  Since there is a deadweight loss, society as a whole is worse off Price Ceilings  Price Ceiling- Maximum price at which certain g/s may be exchanged to keep g/s affordable  Examples: oil, natural gas, and rental housing  Price ceiling set above equilibrium price has no effect because free market equilibrium remains attainable; non-binding  Price ceiling set below equilibrium price will lower the price = binding o Binding price ceilings head to excess demand, which the quantity exchanged being less than in the free market equilibrium Consumer surplus = Area A and C; ½ [(Pmax- Pceiling) + (Pqd – Pceiling)](Qs) Producer surplus= Area E; ½ (Pceiling – Pmin)(Qs) Deadweight loss = TSo – Tsceiling; (A+B+C+D+E) – (A+C+E)= B+D Allocating a Product in Excess Demand  First come first come basis- long line ups for the product whose demand > supply  Seller’s Preferences- Allocation of commodities in excess demand by decisions of the sellers  Ration the Product- If government dislikes allocation of products by line ups or seller’s preferences, they print only enough ration coupons to match the quantity supplied at the price ceiling and then distributes the coupons to would-be purchasers, who then need both money and coupons to buy the product Black Markets  Black Market- A situation in which goods are sold at prices that violate a legal price control  Binding price ceilings always create the potential for a black market because a profit can be made by buying at the controlled price and selling at the illegal black market price < Extreme case: If all available supply of Q2 were sold on a black market, the price to consumers would rise to P2; since black marketers buy at the ceiling price of p1 and sell at the black market price of p2, their profits would be represents by the green coloured area  Three goals gov
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